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Why I’m shorting the euro

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Published: Jan 11, 2012 12:01 a.m. ET

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Heads I win, tails you lose and this is why I am shorting the Euro.

Once in a while you are faced with an investment that is so obvious that you may decide not to participate as you convince yourself that you are missing something. Last month I reviewed one of these investments when I recommended a long term short on the Japanese Yen. (See Dead Yen Walking). Shorting the Yen will be extremely lucrative over time however the trade can take months before it materializes. Today I would like to recommend another currency trade, one with a shorter life spends, and that is already in play: short the Euro.

To understand where the Euro is going don't focus on the small fries that are Greece or Portugal, pay attention to the larger economies such as France, Spain and particularly Italy. As I am writing these words the Italian Govt Bond 10 Year Gross Yield is in excess of 7%. We all know that such high rates are unsustainable long-term and will drastically impact the Italian economy. As the economy crumbles under the weight of high rates, the government income shrinks and the bond market demands even higher yield to compensate for the risk of default; the perfect illustration of a vicious cycle.

The European situation is deteriorating rapidly and when looking at it objectively we can draw three possible outcomes going forward.

1) The situation resolves itself as the economy starts to improve and tax revenue increases.

Bond vigilantes move towards other victims and rates drop to an acceptable level. Italy enters into an austerity phase and convinces the market that this time it is different. I would put a probability of less than 10% on such a scenario.

2) The Germans refuse to provide unlimited help and turn toward a more protectionist approach where the mood switches to "Everyone for himself.”

A scenario with a higher probability than you may expect. The question for the Merkel's government today is: how can they sell to the average German that he needs to pay for his neighbors excessive expenses, early retirement and refusal to pay taxes?

We know that Germany has ridden the cheap Euro for 10 years now, becoming the leading exporter (together with China) of goods to the world. I am convinced that under the old currency system, the Deutschmark would have been priced much higher reducing the competitiveness of Germany and making their goods much more expensive to other European countries. In a certain way, because of the Euro, Germany played a similar game as China; manipulating its currency to gain a competitive edge over other countries.

It may appear normal for other European nations that Germany now pays the price for the fruits it collected over the last ten years, however I doubt that this will be an easy sell to the German electors. Under this protectionist scenario, the European Union collapses sending the world into a recession or even worst a depression.

I put a probability of 30% toward this scenario. No doubt that the end of the Euro will be discussed at length and will sometimes appear inevitable, however the pain to be felt by Germany under such a scenario is making me doubt that it will materialize.

3) The European Union convinces Germany to dilute its own wealth and the ECB enters into a massive Quantitative Easing program where billions are printed to buy the Italian, Spanish and other Club Med debts.

Such an approach would de facto modify the sovereignty of the members of the Union and open the way toward a United States of Europe with a Central government and diluted powers for sovereign states. It may take years to be fully functional, but the amalgamation of the different debts and the necessity to align the fiscal regime of all would definitely aim in this direction. This is the scenario with the highest probability, in excess of 50%. Why? Because no politician wants to be pointed at as the one who broke Europe and as we know, politicians always take the path presenting the least pain and the least resistance.

You may agree, or not, with my assessment of the situation but one thing remains; in the two most probable scenarios the Euro currency will drop in value. If Europe collapses we go sub par with the USD and if the ECB starts the printing press (without the actual sterilization) the Euro drops to 1.10 or less. There you have it, two sides of the coin presenting the same result, heads I win, tails you loose. The Euro will continue to go down in 2012.

There is a risk to this trade, and the risk doesn't sit on the Euro side of the fence. When you short the Euro, you will need to go long another currency. The most obvious trade would be to short
EURUSD, +0.4665%
(Short Euro, Long US dollar) however, if the Federal Reserve decides to enter into a QE3 program, the value of the USD would drop, sending the EURUSD higher. You may also decide to go long with a currency presenting little risk of QE such as the Canadian dollar (Short
EURCAD, +1.1255%
However in the case of a collapse of the European Union the Canadian dollar, which continues to be perceived as a risk asset, would also drop drastically. Finally you may want something more exotic and go Long Gold and Short Euro (XAUEUR) In this trade you win with a dropping Euro and with the impact of a QE3 on gold. My recommendation would be to split the risk and invest in the three trades. Please use stop-loss.

Disclaimer: Clover is currently short EURUSD, Long XAUEUR and Long GLD in some of its client's accounts. Clover has no positions in EURCAD, FXE and FXC. Clover has not made any transactions in any security mentioned in the past 72 hours and will not make any purchases or sales in the 72 hours following publication of this article.

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